Economics101

Innovation, Efficiency, and Competition:

The Invisible Hands of Wealth Creation

August 2012

Jobs and the economy.Being an election year there is plenty of
talk about jobs and the economy, about the price of fuel and food, about the
balance of trade amongst nations, accusations of misguided policies of
incumbents and past administrations, and about the appropriate amount of
taxation going forward.What has
frustrated me is the fact that these discussions are incredible shallow, and
virtually nobody can explain how wealth and value actually gets created in the
first place.

How does wealth get created?Where do jobs come from?

This note attempts to explain the basics of wealth creation in
society.Its purpose is to offer the
reader a guide to a basic understanding of economics. It does not talk about
wealth accumulation or how to get rich.My
goal is to help you interpret the issues being discussed in an election season.Longer term, it will help you understand the
path that society needs to stay near in order to dig itself out of this hole
we’re in. I could walk the reader
through introductory concepts, but I’m hoping to keep this note accessible by
teenagers, so I’m going to dive right in and get to the point:

·Wealth is not money; wealth is the set of things
people create, provide, want, or consume, usually using money as the exchange
medium. Money is a way of moving wealth around.

·Wealth distribution and redistribution for
occurs in the transaction of the marketplace.

·The essential sources of new wealth creation are
efficiency and innovation.

·Market controls and price manipulation are
subject to the laws of supply and demand and reduce the amount of resources
that would have otherwise been available for wealth creation.

·The Government takes a piece of every
transaction

·The data shows that 20 percent is the most the
government can take before the invisible hands of wealth creation are tied.

Money is a way of moving wealth.

If you want to create wealth, it will help to understand what it is.
Wealth is not the same thing as money. Wealth is as old as human history. Money
is a comparatively recent invention.

Wealth is the fundamental thing. Wealth is stuff we want: food,
clothes, houses, cars, gadgets, travel to interesting places, and so on. You
can have wealth without having money. If you had a magic machine that could on
command make you a car or cook you dinner or do your laundry, or do anything
else you wanted, you wouldn't need money. Whereas if you were in the middle of
Antarctica, where there is nothing to buy, it wouldn't matter how much money
you had.

Wealth is what you want, not money. But if wealth is the important
thing, why does everyone talk about making money? It is a kind of shorthand: money is a way of moving wealth, and in
practice they are usually interchangeable. But they are not the same thing, and
unless you plan to get rich by counterfeiting, talking about making money can
make it harder to understand how to make money.

Money is a side effect of specialization and division of labor. In a
specialized society, most of the things you need, you can't make for yourself.
If you want a potato or a pencil or a place to live, you have to get it from
someone else. [1]

Wealth is distributed through
the transaction.

The source of all wealth distribution is in the transactions that take
place amongst individuals and amongst groups of individuals.That transaction occurs at some price.If the buyer and seller both think they are
getting a good deal, then there is wealth
being created for both parties.There
is plenty more one can say about the subject but yes, it’s that simple.I’ll say it again in other words: as long as
the transaction price is between actual cost to the provider and maximum value
to the consumer, then the transaction represents a little bit of wealth
creation for both parties.

Innovation and efficiency is the
source of new wealth creation.

The total value of a transaction is the difference between the maximum value the
consumer places on a product or service and the actual cost to the provider to
deliver the product or service.If the
provider can do things more cheaply, then total value can increase without
changing the transaction price,Similarly,
if a new product or service has features or quality that exceeds what was
available in the past, then total value of the new product or service is
greater than that of the old product or service.

The transaction and the role of innovation and efficiency in wealth
creation can be illustrated via the following figure:

Figure 1. When the price of a product or service floats
between the maximum value placed by the recipient and what it costs the
provider to deliver that product or service, then the transaction puts a little
wealth into the pockets of both parties.Innovation leads to things of greater value, while efficiency increases
the amount of money or resources available to do other things.

Innovation creates new products and services that consumers are more
interested in.Resources thus flow in
the direction of the most valuable innovations.

Figure 2. The invisible hand of innovation-based wealth
creation

Competition on price is the “invisible hand” of the marketplace that
pushes prices lower, thereby redistributing wealth from producers to
consumers.Simultaneously, more
efficient producers can deliver at lower cost, thereby gaining more wealth with
each transaction.These concepts can
also be illustrated:

Figure 3. Wealth redistribution due to competition and due
to efficiency

Market Manipulation: Supply,
demand, and the source of wealth destruction

Now we can turn our attention to the laws of supply and demand.Before I do I need to say something about price.The price of anything is like a butterfly.The seller might want to be in control of the
price but, like the butterfly, it is forced up and down by a number of forces
that interact in complex ways.There is
competition, but there is also intentional and unintentional manipulation by
government, by groups of providers, and by groups of consumers.Sometimes this manipulation is called
exploitation, and it’s usually enabled by a lack of timely knowledge on the
part of the exploited.

Forcing prices lower will generally increase demand but without finding
ways to do things more efficiently, producers start to walk away - pushing
supplies lower and create shortages.Conversely, pushing prices higher decreases demand but can lead to
increased supplies and wasteful surpluses.We can and should view shortages and surpluses as an indicator that the
price is being manipulated one way or another, and when the transaction wealth
for either the buyer or the seller gets too small, people just walk away.

Figure 4.Supply and
Demand in the face of price manipulation. If the value of the
transaction for the seller gets too small,
supplies shrink and shortages occur (top).As the transaction value for the buyer shrinks, supplies grow and
useless surpluses exist (bottom).

The Government Takes
from Every Transaction

Now I want to address the role of taxation and regulation.It does not matter if you are the consumer
or the provider, the government always gets a piece of both sides of that
transaction.If you think of it in terms
of the transaction wealth as being shared with the government, we can see that
wealth is being redistributed from private parties to the government.In terms of the role the transaction plays in
the concept of the pursuit of happiness, we see that private entities compete
with the government.

Figure 5. While transaction price determines incremental
wealth for producers and consumers, the government takes a chunk of that wealth
from both parties.It’s a different
amount taken from both sides, depending on myriad factors.

A note about the government as a provider and a consumer:
When the government takes from the transactions it gets a pot of money to
invest.It generally becomes a consumer
that gets to influence what goods or services it wants to consume.The government then gets the opportunity to
redirect resources toward innovation it wants to see, and as long as it
encourages or enforces competition, it will also help generate new wealth from
the invisible hand of efficiency.As a
service provider, the government is generally known for inefficiency, and that
is probably connected to the lack of competition in government-provided
services.Conversely, if the government
throws your money away on loans to Solyndra , then there is a good chance it’s
just redistributing wealth without any new wealth creation.That’s incompetent at best, corruption at
worst.

If the total value of all transactions is called the Gross
Domestic Product (GDP), then according to data spanning the last 60 years, the federal
government alone gets, on average, about 20% of each and every
transaction.Here’s the evidence:

Figure 6. Federal revenues are essentially a fixed income
at 20 percent of GDP.State and local
taxes (not shown) add another 15 percent or more.They can’t get any more because I believe
that’s the point at which incremental wealth creation in the transaction
becomes so small that the buyer or the seller walks away from the
transaction.That’s just a hypothesis on
my part and requires more study to validate. (Source: http://reason.com/blog/2010/11/29/the-remarkably-stable-amount-o)

Listening to so-called experts about this stuff is
mind-boggling.Some of them argue about
what we should do to increase GDP, some want to increase revenue.Some want to increase or decrease how the
consumers get taxed, while others want to increase or decrease how producers
get taxed.Finally, there’s the Federal
Reserve and the effect of it’s ability to simply print money or otherwise
influence the number of transactions.It’s very confusing, and in the end it’s my opinion that they rarely say
anything that makes much sense or is of much use to anyone.

One thing we know for a fact: federal revenues seem to be
maxed out at 20% of GDP.I don’t know
why, but that’s the way it is. That’s a fixed income.The federal government wants to spend more,
so what does it do?It pulls out your
credit card and keeps spending!Day
after day for nearly 40 years the federal government keeps racking up credit
card debt and pretends that it doesn’t matter.It does matter, and nothing is too big to fail.That irresponsible behavior is morally wrong
and financially stupid for individuals, for families, and for entire federal
governments.

Figure 7. Federal
revenue is influenced by many factors but seems to be capped at 20 percent of
total value of all the transactions (i.e. GDP).This illustration is similar to what is called a Laffer Curve, that
basically says there is some sweet spot of taxation that maximizes
revenues.I think it’s a simple and
truly flat 10% tax on all incomes, personal and corporate, regardless of income
level.This frees up maximum resources
for innovation and efficiency, the source of new wealth.

Jobs and the economy.It’s an election year and the factors
influencing job creation and improving the economy is the main topic of
discussion.What I’ve described here
tries to explain that wealth creation comes from innovation, efficiency, and
competition.If you want a strong
economy and lots of jobs, then you need to maximize the resources available for
individuals on both sides of the transaction to decide what is efficient and
useful and quit screwing around with the current shell game of price
manipulation and inefficient, complex taxation policies.In my mind that implies lower uncertainty via
Look for a president and for representatives who acknowledge the 20% hard limit
on federal spending and the need to pay down the debt.Look for a president who seeks high
efficiency in government functions and low uncertainty via simplified taxation
policy.